EC Do Bond Prices Have Momentum?

Here’s a strange thought from Jeff Gundlach, one of the world’s largest bond managers:

“If you get above 3%, then it’s truly, truly game over for the ancient bond rally.”

And here’s Bill Gross from earlier this month:

This is super interesting. In essence, two of the world’s most famous bond managers are making massive secular bond calls based on…lines on a chart?

This raises a couple of important questions: 1) what is this theory of inflation? And; 2) does inflation (and therefore bond prices display long-term momentum? These are big questions so let’s think about this some more.

Now, the interesting thing about using charts to read the bond market tea leaves is that it implies that interest rates are primarily a momentum phenomenon. In other words, when interest rates break X% then there’s a probability that they will continue higher or lower. As I’ve noted before, momentum works in an equity market index fund for fundamental reasons – the fund is essentially a rules-based product that sells losers and buys winners thereby attaching itself to long-term growth in corporate profits. But should momentum work in the bond market?

What Drives Bond Prices? 

First, let’s look at a simple example of stocks and bonds. Stocks have momentum in the sense that corporate profits are generally rising. An equity instrument is attached to that stream of increasing income. An equity index fund is a rules based system that always maintains exposure to this growing pie of income. Therefore, it exhibits momentum.

A bond is an instrument with a fixed income stream. A high-quality bond exhibits momentum for the same basic reason that the equity market index fund does – it has little risk of permanent loss because the instrument is designed not to expose the investor to credit risk. So, the equity market index fund sheds losers before they become losers and the high-quality bond is an inherently safe instrument with low principal risk. But when we analyze bond returns and the risk of owning bonds at current rates we aren’t trying to analyze whether that bond will have momentum. We really want to know if interest rates have momentum because we want to analyze the real opportunity cost of buying bonds today versus buying bonds later.

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Kevin Richards 1 year ago Member's comment

Carl Dincesen, what's your take on this?

David Haggith 1 year ago Contributor's comment

It is simplistic to write as if the only factor driving interest on bonds up faster is inflation. Look at the numerous people who KNOWINGLY purchased bonds with negative real interest, meaning that they knew, once inflation was factored in, the interest on their bond would actually be negative. That shows there are other major factors in what people will pay for a bond and, therefore, where its interest can go than just inflation. People were scared and were willing to take calculated losses from inflation on the belief that those bonds were the only safe place to stand. Inflation is only one factor that drive interest rates in bond. Fear, as described above, is another. Therefore, if you have reason to believe fear will be rising, you have reason to believe upward momentum in interest rates will back off. The biggest factor of all is supply and demand. It's quite simple, if you have a massive supply of bonds to sell and cannot attract anywhere near enough buyers to raise all the money you need, you're going to have to up your interest game. Inflation being anticipated down the road only means you have to up it for that, too. So, when it comes to momentum, if you can look down the road and see that the supply of bonds is burgeoning AND you can see that the demand for bonds from the largest buyer of bonds (the Federal Reserve) is decreasing, you KNOW (even in an inflation neutral setting) there is going to be upward momentum building in interest rates. Of course, if you can know that inflation will go up or down, you should factor that into your assumptions about the momentum of bond interest as well.

Anastasija Janevska 1 year ago Member's comment

These are interesting points David Haggith. Are there any other factors that, to a lesser extent, also come into play?

David Haggith 1 year ago Contributor's comment

Thanks, Anastasjia. (Love that name by the way.) I'm sure there can be many other factors, but I think supply and demand is the big one another. Another factor would be opportunity cost. If you're going to buy a bond, you have to ask yourself, "What other opportunities are there for me with this much money that are similar in risk, but maybe better in reward, or the same in reward but lower in risk." So, right now, with stocks looking risky in response to what was happening in the bond market, some people might actually decide to buy and hold bonds for safety (different than buying into a bond fund because bond funds can crash due to lack of liquidity (like a run on the bank); but bonds can be safely held and keep paying predictable interest for years. So, there is an equilibrium kind of force that sets in when stocks start to really crash, and people move to buying and holding bonds directly. That onslaught of buying creates more demand for the bonds and starts lowering their interest back down. That in turn, will make the stock market that is nervous right now a little less nervous if it sees bond yields going back down. In fact, one of the things that makes it nervous about seeing bond yields go up is that investors fear other investors will move out of stocks. So, it's a dynamic relationship like a game of tug-o-war.

Norman Mogil 1 year ago Contributor's comment

An excellent argument on all points.

I find that Gross and Gundlach often make pronouncements based on their book-- what bets they have already placed.

Duanne Johnson 1 year ago Member's comment

Can you elaborate on this Norman Mogil?

Norman Mogil 1 year ago Contributor's comment

Take #BillGross. In the past there have instances where Gross made very strong statements about the future of #bonds. For example, when the Fed decided to reduce its purchases of bonds, Gross called for the selling of bonds because in his words " who will buy bonds? " if the Fed is not there. He happen to short the bond market and this statement is consistent. As it turned out, he was wrong and had to cover his short position in a hurry. Soon after the Fed' s announcement of winding down QE, bond yields fell steadily.

Duanne Johnson 1 year ago Member's comment

Thanks Norman, I always find your insights to be very helful.

Gary Anderson 1 year ago Contributor's comment

Great article. Will tantrums and tantrum mongers ever go away? Apparently not. Also, with demand for bonds increasing due to use of bonds as collateral, there is even more reason to believe that bonds won't always even behave rationally as we think they should. Finally, weakness of labor will impact inflation negatively. Asset inflation is actually an attack on labor, and the Fed has nothing better to do than tamp down wages. Until that behavior stops, it is hard to see real secular inflation and secular bond price decline.

Carol Klein 1 year ago Member's comment

What do you think could get the Fed to change that behavior?

Gary Anderson 1 year ago Contributor's comment

The essence of capitalism is the control of wages. I don't see the Fed changing that approach, Carol.

Craig Newman 1 year ago Member's comment

Too true.